Reference no: EM133043313
Question - Management are considering a project to buy and operate a major item of equipment. Your boss is extremely enthusiastic about the project, arguing that (i) it has a very high rate of return and acceptable payback period, and (ii) it will definitely add to shareholder value. The equipment costs $385,000, is anticipated to be sold at the end of year 5 for $20,000, and will be depreciated straight line over the five-year period. The equipment will be used to manufacture a new type of electrical switch which will be sold at a price of $2.50 per unit. Expenses associated with this project other than depreciation can be assumed to be 51% of the sales revenue. The relevant discount rate is 12.5% and can be assumed to be the hurdle rate for both the accounting rate of return and the internal rate
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Year
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Sales (units)
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|
1
|
58,000
|
|
2
|
72,000
|
|
3
|
86,000
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4
|
100,000
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5
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114,000
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1) Calculate the projected yearly profit and operating cash flows.
2) Prepare a table showing ALL the project's net cash flows, excluding working capital requirements.
3) Calculate the accounting rate of return.
4) Prepare a table of cumulative cash flows suitable for calculating the payback period, and calculate the payback period.
5) What can you conclude about the project and about the statements made by your boss, based solely on the project's ARR and payback period?